Section 2: Basic Energy
Economics Analysis
Dr. Congxiao Shang
Room No.: 01 37P
Email: [email protected]
ENV-2D02 (2006):Energy Conservation
2.1 Introduction
• Decisions to an energy project should largely be
made on the basis of economic analysis.
• Imperfect analysis of energy issues can be flawed,
and give misleading answers on decisions made.
A project costs:
£100
To implement
?
Viable
1st
2nd
3rd
4th
5th
£20
£20
£20
£20
£20
Annual Saving
2.1 Introduction
• An energy project
should consider:
- whether to promote energy
conservation, i.e. energy
saving,
Main objective: To assess
whether an energy project is
economically feasible.
- or to develop new energy
resources, such as wind, tidal
energy, solar, hydrogen and
biofuels etc
2.1 Introduction
• Decisions to an energy project should largely be
made on the basis of economic analysis.
• Imperfect analysis of energy issues can be flawed,
and give misleading answers on decisions made.
A project costs:
£100
To implement
?
Viable
1st
2nd
3rd
4th
5th
£20
£20
£20
£20
£20
Annual Saving
2.1 Introduction
• Before answering the question – correctly…
Let’s revise some concepts for simple cost benefit analyses.
Those who have done Environmental Economics will
know some simplifications in what is described below.
2.2 Discount Rate
The concept of discount rate is introduced because
of the following facts :
 On the one hand, money borrowed to implement a project
will incur interest charges which are compounded each year.
 On the other, the value of money or saving declines with
time, due to inflation.
 To simplify the analysis, we use the present time as a
reference for analysis (hence, interest charge is not an issue),
the concept of a Discount Rate to account for inflation, and
the Net Present Value (NPV) to evaluate the present value
of future savings.
2.2 Discount Rates
The term, discount rate , is used to determine
the present value of future cash flows arising
from a project, i.e. the discounted value of future
cashflows, due to inflation.
 The actual value of the discount rate is equivalent to the
basic interest rate that a high-street bank is charged to
borrow funds directly from the Central Bank.
2.2 Discount Rates
We can analyse the
economics of a project
using the discount rate
in two ways:
For a conservation project
which costs £100 to implement,
we save £20 p.a. with a
discount rate, r = 5%:
Year
Individual discount
approach
Cumulative discount
approach
0
1
2
3
4
5
6
7
Capital
Outlay
£100
-
Fuel Discount NPV of fuel
Saving Factor
saving.
£20
£20
£20
£20
£20
£20
£20
0.952381
0.907029
0.863838
0.822702
0.783526
0.746215
0.710681
£19.05
£18.14
£17.28
£16.45
£15.67
£14.92
£14.21
1
(1  r )n
2.2 Discount Rates
The discount factor of the
year n can be computed
from the formula:
1
n
(1  r)
Year
0
1
2
3
4
5
6
7
Capital
Outlay
£100
-
Fuel Discount NPV of fuel
Saving Factor
saving.
£20
£20
£20
£20
£20
£20
£20
0.952381
0.907029
0.863838
0.822702
0.783526
0.746215
0.710681
£19.05
£18.14
£17.28
£16.45
£15.67
£14.92
£14.21
The NPV( Net Present Value)
= (value of saving in the year n)  (the discount factor of the year):
reflects the value of the fuel saving would have if it were accounted at the
present time rather than some years into the future.
It accounts for the effect of inflation.
1
(1  r )n
2.2 Discount Rates
The discount factor of the
year n can be computed
from the formula:
1
n
(1  r)
Year
0
1
2
3
4
5
6
7
Capital
Outlay
£100
-
Fuel Discount NPV of fuel
Saving Factor
saving.
£20
£20
£20
£20
£20
£20
£20
0.952381
0.907029
0.863838
0.822702
0.783526
0.746215
0.710681
£19.05
£18.14
£17.28
£16.45
£15.67
£14.92
£14.21
To sum up, the accumulated NPV fuel saving over the first five
years is £86.59, which is still £13.41 short of repaying the initial
capital of £100, i.e. a loss of £13.41, the project would not be viable
However, if the project’s life span is 6 years with no further cost,
the total NPV becomes £100 +£1.51
 For 7 years life span, the NPV = £100 + £15.72, certainly viable!
2.2 Discount Rates
Cumulative discount approach
Year
Capital
Outlay
Fuel
Saving
0
1
2
3
4
5
6
7
8
9
10
£100
-
£20
£20
£20
£20
£20
£20
£20
£20
£20
£20
Cumulative
Discount
Factor
0.952381
1.859410
2.723248
3.545951
4.329477
5.075692
5.786373
6.463213
7.107822
7.721735
Cumulative NPV
of fuel saving.
£19.05
£37.19
£54.46
£70.92
£86.59
£101.51
£115.73
£129.26
£142.16
£154.43
It gives the cumulative factor of discount up to and including the year n.
it is usually quicker to use such values rather then some the individual
discount values as shown in the previous table
2.2 Discount Rates
How to calculate Cumulative
discount factors?
The Cumulative Discount Factor in year n is the sum of
all the discount factors from year 1 to year n
The Cumulative NPV to year n is the sum of all the
NPVs of individual savings from year 1 to year n;
or
= Annual saving x the Cumulative Discount Factor
2.3 Project life and Choice of
Discount Rate
Project Life depends on a number of factors:
 A single initial cost
 Compensation factors, e.g. fuel price rises
 Offsetting factors, e.g. maintenance charges
 Competing schemes, e.g. a new process that gives more
profit than the saving from the project, for the same initial
investment
2.3 Project life and Choice of
Discount Rate
Life span:
 Small Schemes
no more than 9-18 months
Cost effective
 Exceptional Schemes with pay back period 2 years
will be considered; Over 5 years rarely considered
2.3 Project Life and Choice of
Discount Rate
• Discount rates vary from time to time depending
on the economic climate;
• Different organizations will set different target
discount rates
1) A higher discount rate 10%+ favours coal and fossil fired
power generation.
2) Moderate discount rates ~5% tend to favour gas and nuclear
options.
3) Low discount rates, even≤ zero, favour conservation and
renewable energy.
2.4 Fuel Price Rises
2.5 Negative Discount Rates
2.6 Internal Rate of Return (IRR)
At one discount rate, the NPV over the life of the project is
0, this corresponds to the Internal Rate of Return.
The figure shows the results of analyzing
the example in 2.2 with differing discount
rates for a project life of 7 years.
The NPV becomes zero for a discount rate
of 9.2% - the Internal Rate of return.
The graphical approach is much quicker
to determine the IRR than a numeric
method.
2.6 Internal Rate of Return (IRR)
•The IRR is the discount rate that
makes net present value of all cash
flow equal zero or the project will
break even.
• If you apply a discount rate to future
cashflows that is higher than the IRR,
the project will make a loss in real
terms. If you apply a discount that is
lower than the IRR, the project will be
profitable
Profitable
Non-profitable
2.7 The Changing Price Structure
for Electricity & Gas
Electricity
Charges will be in three parts:
1.Charge to the Regional Electricity Company
(REC) for transmission which will be the same
for all suppliers
2.Charges for the actual units used
3.A charge for meter reading
Gas
Duel fuel
2.8 Trends in Energy Tariffs
In the case of electricity, the corresponding tariffs
are: (from WEB Site, 19th December 2005)
EDF Tariff
Standing Charge per annum
unit charge
£59.24
6.56p
PowerGen Tariff
First 800 units (p)
Remaining units (p)
10.7415p
8.1165p
Scottish Power Tariff
First 900 units (p)
Remaining units (p)
12.31p
7.33p
2.8 Trends in Energy Tariffs
Comparison of three electricity tariffs
350
Scottish Power
300
EDF
PowerGen
250
200
150
100
50
0
0
500
1000
1500
2000
2500
3000
3500
4000
2.8 Trends in Energy Tariffs
In the case of gas, the corresponding tariff for PowerGen:
(19th December 2005)
Standing Charge
unit charge for first 4572 kWh
unit charge for gas consumed above
the threshold
0
3.63
2.05
Unlike the electricity, the gas tariffs were more uniform across
the country. However, there are variations recently due to
competition introduced to the distribution of gas as well
2.9 Some Examples on loft insulation
Example 1: Area of average house = 49m2
Assume house with no loft insulation

Heat Loss through roof (WoC-1)
Annual Energy Loss (GJ)
Full rate Electricity
100
Off Peak Electricity
90
Gas
75
Gas condensing Boiler
90
Pre War Post
War
146
85
30.7
17.8
625.09
484.49*
336.85
272.47*
233.09
164.96*
194.24
137.47*
362.43
282.06*
195.31
158.63*
135.15
96.04*
112.62
80.03*
Situation after insulation measures
 After
Annual Energy Loss (GJ)
3.34
Full rate Electricity
100 68.01
52.85*
Off Peak Electricity
90 36.65
29.72*
Gas
75 25.36
18.00*
Gas condensing Boiler
90 21.13
15.00*
Saving
Post War House
14.5
295.24
229.21*
159.10
128.91*
110.09
78.04*
91.74
65.03*
* Energy costs based on tariffs from Dec.
2003. The differences indicate the rise in
prices over last two years.
2.9 Some Examples on loft insulation
Example 2: Area of average house = 49m2; some
house with 50mm insulation already
 Gas heated (condensing boiler)
case again
 Initial consumption will be
6.48 GJ (c.f. 30.6 GJ) for prewar house.
 Initial annual consumption
for post war house = 5.63 GJ
(c.f. 17.8GJ)
NOTE: you will be shown how
to calculate the values of 6.48
and 5.63 later in the course.
Calculation:
2.11 Criteria for Investing in a
Project
 The project must have a net positive present
value over its life span
 The project has the most favourable rate of
return when compared to other projects, or
to direct investment (i.e. use IRR as an
indicator here).
 If money has to be borrowed to undertake
the project, then the rate of return must be
greater than the borrowing rate.
 The rate of return must be significantly
above the direct investment rate as capital is
tied up and cannot be used for other things.
2.2 Discount Rates
Example of a compounded interest rate:
A project is cost £100, borrowed at 5% interest rate
After one year
The total amount repaid: £100×1.05=£105
After two years
The total amount repaid: £105×1.05=£110.25
By the end of fifth year
The total amount repaid: £100 ×1.055 = £127.63
not £100 +5 × £100 × 5% = £125 in the simple interest
case
2.2 Discount Rates
Optional Information: In fact a discount rate is slightly different from the
interest rate, mathematically…
The discount rate is based on the future cash flow in lieu of the present value of
the cash flow.
E.g. we have $80, and we buy a government bond that pays us $100 in a year's
time. The discount rate represents the discount on the future cash flow:
(100-80)/100= 20%
The interest rate on the cash flow is calculated using 80 as its base:
(100-80)/80= 25%
Hence, for every interest rate, there is a corresponding discount rate, given by:
d= i/(1+i)
Again when referring to a cash flow being discounted, it will likely refer to the
interest rate and not the proper mathematical discount rate.
However, the two are separate concepts in financial mathematics.
2.10 Some Comments on these
examples.
• The examples show exactly how cost effective loft insulation can be
particularly if there is no insulation to start with.
• It pays to install thicker insulation at outset as it will be cost effective (even
if there is no grant).
• It becomes progressively uneconomic to upgrade insulation standards, and
that if 100m already exists, it is not cost effective to upgrade, even though it
is cost effective to put in 150mm from scratch
• The present grant system is a disincentive to those who have spent money in
the passed.
• Grants of up to 90% are available for pensioners
• It is argued that the poor cannot afford the capital outlay. The poor will not
have condensing boilers, and are more than likely to have electric heating,
and pay back is within a few weeks. With an extended 90% grant, the
capital cost is no more than £10, so this can hardly be construed as a
deterrent
Or see the lecture notes
Scotland
Шотландия
Scottish Hydro
Structure of Electricity Supply in
early 1990s
Структура
системы энергоснабжения
в начале 1990 г.г.
Scotland Шотландия
Scottish
Power
Northern
England &
Wales
NORWEB
Yorkshire
Англия
и
Уэльс
East Midlands
MANWEB
Midlands
SWALEC
SWEB
•
two companies
две компании
England and Wales
Англия и Уэльс
12 Regional Supply Companies
12 региональных компаний
Eastern
London
Southern
Vertical Integration
Вертикальная интеграция
SEEBOARD
also Distributed Network
Operators
а также распределяющие
сетевые операторы
Distributed
Distributed Network
Network Ownership
Ownership in
in 2005
2004
Владение распределительной сетью в 2005
Scottish & Southern
Scottish Power
United Utilities
Mid American
Electricité de France
Western Power
Distributed
Network
Ownership
Владение
распределите
льной сети
PowerGen
Central Networks
Aquila
Scottish & Southern
Scottish Power
nPower
PowerGen
Electricité de France
Regional
Supply
Ownership
Владение
региональных
поставщиков